6. Forex market stages

Markets are in their essential nature fractals. The Wikipedia definition of a fractal is as follow: “A fractal is a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole”. No matter what time-frame you are looking at, the basic unit of a market is comprised of four stages. These stages always repeat themselves in the same sequence and are the key to correctly determining the overall direction of the market. 

 

The first step of your forex market analysis is to make a correct decision whether to buy or sell a given currency. The key to determining market direction correctly is knowing the market stage of a given time-frame you plan on trading. Each stage has its own characteristics and requires different trading approach. For example, profitable strategy for stage 2, could be deadly in stage 1&3 and so on. Let`s now have a closer look at the individual stages.

Stage 1: Accumulation phase

Actions allowed:  Buy and Sell

This stage follows after a severe downtrend (stage 4), which is usually characterized by extreme fear. A lot of traders are short entering into stage 1. Smart money is covering their remaining short positions by buying from the dwindling supply of terrified sellers. Characteristic emotions for this market environment are uncertainty and ambivalence. Sellers are losing dominance quickly and bulls are gaining momentum. Both buyers and sellers are in a relative equilibrium. On a chart, the first hint of the beginning stage 1 is a break of major resistance (refer to support and resistance section). Usually, range bound trading follows. During a stage 1, a seasoned trader looks to buy in the area of support and looks to sell in the area of resistance.

Stage 2: Uptrend

Actions allowed: Buy only!

During accumulation phase (Stage 1), professional traders are usually getting out of their short positions and are starting to accumulate the currency from the shrinking number of available sellers.  Both active buying and shorts covering significantly increase demand, which leads to higher prices.  Markets enter into stage 2 uptrend, when bulls gain dominance and are able to push prices beyond the range bound trading characterized in stage 1. The dominant emotion for stage 2 is greed.  It is also a stage, when it is easiest for an average trader to make money. On a chart, the stage 2 is characterized by a series of higher lows and higher highs. During a stage 2, seasoned trader looks to buy on corrections.  

 

Stage 3: Distribution

Actions allowed: Buy and sell.

As stage 2 uptrend progresses, professional traders with long positions, start taking profits by selling. As more and more participants have already bought and the price is still higher, there are less and less available buyers remaining.  Eventually, the market reaches a point, when there are no more buyers left to buy at still higher prices. A sell off follows and when there is a break of major support, the market enters stage 3 distribution phase. This market environment is characterized mostly by uncertainty similarly as stage 1. Sometimes stage 3 transforms into a stage 4 downtrend rather quickly. During a stage 3, seasoned trader focuses on buying support and selling resistence. 

Stage 4: Downtrend

Actions allowed: Sell only!

Stage 4 completes the entire cycle. After a break of major support, we can consider stage 2 uptrend over. At this time, the pros are closing their longs and are getting ready to position themselves short for the upcoming downtrend. When supply totally overwhelms demand, the market takes a huge fall. Emotion dominating the market at this time is fear. Stage 4 usually lasts shorter and is more severe than stage 2 uptrend. The reason is that fear is more powerfully motivating emotion than greed.  On a chart, the stage 4 is characterized by a series of lower lows and lower highs. During a stage 4, seasoned trader looks to sell on corrections.  

As mentioned previously, understanding and using the concept of stages correctly is a key to determining the overall direction of any given market. However, experience is needed to make the proper distinctions. For example, what happens when market starts moving sideways? Assuming the previous move was up, are we now in stage 3? Or are we dealing with a correction within a stage 2 uptrend? A good rule of thumb is: “Market enters a stage 3 after a break of major support”.  In order to further deepen your knowledge of technical analysis, read a book called: “Elliot wave principle” written by A.J. Frost. The book will provide you with a valuable insight into the types of price corrections allowing you to make further disticntions.